‘Think Of Oxygen’: One Bank (Still) Thinks There Has Never Been A Better Time To Be Long Commodities

As you may or may not be aware, Goldman has been hawking this long commodities call for quite some time and thanks to a confluence of factors (not the least of which is obviously crude, which continues to make new three-year highs seemingly with each passing geopolitical escalation, buoyed by the prospect of supply disruptions against a backdrop of robust demand and undeterred by the resurgent greenback) it’s playing out for them. Through last week, commodities were the best performing asset YTD:

Crude came off a bit on Tuesday, but spiked on Monday amid fresh jitters around the future of the Iran deal, which was thrown further into question when Netanyahu delivered a “presentation” based on secret files that apparently document Tehran’s nuclear ambitions.

And so, on Tuesday, Goldman is out with another sweeping piece on commodities echoing their February 1 call when the bank said they’re now “the most bullish in a decade” on commodities.

This time, they’re going with the following amusingly cheesy tagline: “commodities at ‘bull’ tilt” and (very) long story short, this is predicated in part on the late-cycle dynamics thesis.

“Based upon the average returns and correlations over each phase of the 1987-1Q2018 period, a classical portfolio optimization for each phase (starting at 60% equity, 40% bonds and 0% commodities) suggests that allocation to commodities should be moderate during an economic recovery, with a weight of just 4%, with the allocation rising as the level of economic activity increases, to 38% in the expansion phase and peaking at 80% in the slowdown phase,” Goldman writes.

Accounting for uncertainty as to where we actually are in the cycle, Goldman goes on to note that maybe your allocation “shouldn’t reach such extreme levels”, but that said, they argue that a tilt towards Overweight is optimal:

We believe the macro backdrop for commodities is as good as we have seen in years, suggesting large allocations to the sector to benefit from such returns. Over the past six months, the sharp ratio of a long commodity position has reached 1.5 with equities offering only a 0.5 sharp ratio.

They also remind you that while it might seem counterintuitive to pile into commodities just when the cycle may be about to turn, it’s actually not. To wit:

Advocating for a more aggressive allocation just when economic growth is beginning to slow might sound somewhat counterintuitive. The reason for this is simple. Financial markets depend upon expectations and hence on expected growth rates in economic activity, which are showing signs of slowing. In contrast, commodity markets depend upon demand levels, which when above supply levels creates market tightness and higher prices. So even if the demand growth slows, as long as the demand level is above the supply level, commodity markets can still generate positive returns. This observation is at the core of the late-cycle playbook for owning commodities and why commodities typically perform the best when other asset classes perform their worst, particularly in relation to inflation. When demand levels exceed the capacity to produce, i.e. a positive output gap, commodities inventories drawdown. The resulting inflationary pressure slows expected growth rates via higher interest rates, which hurts financial assets. In contrast, even if the growth rate of commodity demand slows, the high level of commodity demand continues to deplete supplies, which maintains the scarcity premium in commodity prices, i.e. spot prices trade a premium to forward prices. The scarcity premium creates the positive carry in commodities as the investor buys forward at a discount. Think of oxygen: if it became scarce we would pay an enormous premium today for it as we don’t need it tomorrow if we don’t have it today.

Obviously, that calls for a backwardation chart and by God, they’ve got one for you:

The short-term dollar liquidity “anomaly” that unfolded in Q1 on the back of the LOIS blowout notwithstanding, Goldman argues that higher commodities prices will facilitate easier financial conditions via excess global savings and they of course mention the re-accumulation of EM reserves (more on that here):

The bottom line is that it is this liquidity that sits at the center of the self-reinforcing loop between higher commodity prices (reflation) and stronger demand growth in EM through credit expansion (releveraging), which reinforces global synchronous growth (reconvergence in growth). These are the 3R’s and they are central to our bullish view by creating a positive feedback loop that supports higher commodity prices.

As far as crude goes, Goldman’s “new oil order” appears to be on hold for now (like Albert Edwards’ “Ice Age” thesis). Here’s Goldman with their updated outlook on crude in light of recent events:

We reiterate our summer $82.5/bbl Brent price forecast and expect front-month timespreads to continue to rally, with the momentum in stock declines leaving risks to higher spot and stronger timespreads than we expect in 2H18. Declining inventories, the May 12 deadline for the US to decide on renewing the Iran sanction waivers and the June 22 OPEC meeting all point to rising oil price volatility in coming months. While higher prices will benefit producers, particularly in the US, we believe the lack of spare pipeline capacity in the Permian and a more restrained drilling response as producers focus on shareholder returns will make for a moderate shale production response and provide OPEC with a longer runway to continue the production cuts. This increases the likelihood that OPEC and Russia decide to extend the cuts through 2019 vs. the 300 kb/d increase we have assumed in 2H18 with an additional 500 kb/d cut in 2019. This would create upside risks to our Q1 2019 $75/bbl Brent price forecast.

“Some people think inflation should not rise going into a recession, but actually the opposite is true,” he said, adding that “one should expect that as the next recession approaches, commodities should have a big gain.”

So you know, if you don’t want to take it from Goldman, take it from the man who walks around in public in a clown suit.

Writing about a subject is the best
way to educate yourself about it, and when I flick through past work I remember how much
they taught me, if no one else. Mainly they taught me that I didn’t know very much. But they
also taught me that most other people didn’t know much either. Thus, some key themes
which stand out include the illusory control of policy makers, the presumed knowledge of
those looking to them to actively do good, the ease with which we fool ourselves, and how
best to protect capital in the face of such unavoidable uncertainty. -- Dylan Grice